A Model of Contagious Currency Crises with Application to Argentina
IMF Working Papers, March 1, 1999
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Bibliographic details
- Authors: Nada Choueiri
- Published: March 1, 1999
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451844788.001
Overview
- Author: Nada Choueiri
- Date: March 1, 1999
- Core proposition: Crises transmit across countries by raising the risk premium on government bonds.
- Three possible equilibrium types are identified: “no-collapse”, “collapse”, and “fundamentals”.
Model and equilibria
- Transmission mechanism:
- Crises increase the risk premium on government bonds in other countries, potentially triggering currency crises abroad.
- Three equilibrium types:
- “No-collapse” equilibrium: crises never transmit from abroad.
- “Collapse” equilibrium: crises are inevitably contagious.
- “Fundamentals” equilibrium: crises are contagious if domestic fundamentals are weak.
Calibration and application to Argentina (1995 turmoil)
- Calibration exercise findings:
- The 1995 turmoil in Argentina coexisted with a combination of risk-averse investors and weak credibility in the currency board arrangement.
- Attribution assessment:
- The turmoil could only be attributed to a Tequila effect from the Mexican crisis alone if investors were excessively risk-averse.
Key findings and implications
- Mechanism of contagion:
- Cross-border transmission operates through increases in sovereign risk premia rather than only through trade or direct financial linkages.
- Role of investor behavior:
- Degree of investor risk aversion is a crucial determinant of whether external crises transmit domestically.
- Role of domestic institutions:
- Credibility of exchange rate arrangements (e.g., currency board) affects vulnerability to externally triggered crises.
- Multiple equilibria:
- The existence of “no-collapse”, “collapse”, and “fundamentals” equilibria implies that similar fundamentals can yield different outcomes depending on investor expectations and risk preferences.
Policy-relevant considerations (implied by analysis)
- Strengthening credibility of exchange rate arrangements can reduce vulnerability to contagion when fundamentals are otherwise adequate.
- Monitoring and addressing investor risk perceptions may be as important as improving fundamentals to prevent contagion.
- Recognizing the possibility of multiple equilibria highlights the importance of policy measures that shape investor expectations.
Content in this bundle
- A Model of Contagious Currency Crisis with Application to Argentina - WP/99/29